Are These Tomorrow's Breakout Dividend Stars?

Year after year, credit card processor MasterCard (MA) paid out a simple annual dividend of 60 cents a share. Management thought the payment was a nice gesture to investors, but not really noteworthy in the context of a triple-digit stock price.

Yet last year, MasterCard realized that dividend hikes were the name of the game, and the dividend payout doubled (to $1.20 a share) in one fell swoop.

Frankly, this company is just getting started. MasterCard doubled its dividend again this year, to $2.40 a share. It could double it again in 2014 and 2015 (to $9.60 a share) -- and its payout ratio would still be well below 40%.

As I noted in my first look at dividend growers, so many companies have room to institute major dividend boosts and still have plenty of money left over to reinvest in growth initiatives. In fact, you can find them across many industries.

Take automaker Ford (NYSE:F), which paid out a 40-cent-a-share dividend in 2004 and 2005 but dropped the dividend altogether within a few years. Ford dipped its toe back in the water again in 2011 with a nickel-a-share payout, raising that to 20 cents a share last year.

That dividend now stands at 40 cents a share, good for a 3% yield -- and Ford is just getting started. The company's profits have grown so much that this dividend could well end up at 60 cents or even 80 cents a share by 2015. That would translate into a rock-solid 6% dividend yield.

MasterCard and Ford will have plenty of company as they pursue robust dividend hikes. With the right screening tools and a set of basic criteria, you can find the dividend stars of tomorrow.

First, let's look at the universe of dividend-paying stocks in the S&P 500. More than 70% (359) of companies in the index pay a dividend that equates to at least a 1% dividend yield. If we boost the threshold to a minimum 2% yield, which is right near the average, 230 companies make the cut.

Now, let's focus on companies with such a yield and a payout ratio below 40%. We're still talking about 69 companies.

Every one of them could hike their dividends even faster than their profits are growing, just to get up to the 40% payout ratio that many companies adhered to between the 1940s and '70s. And as I noted in part one of this series, today's economy -- and appetite for dividends -- are quite similar to what we saw back then.

For the sake of conservatism, let's cut the payout ratio below 30%. That leaves ample room for dividend growth. Thirty-seven companies make the cut.

Of all the companies in the S&P 500 with a dividend yield of at least 2%, these 10 have the lowest payout ratios.

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Source: Thomson Reuters

Flipping this analysis on its head, these are the highest-yielding stocks in the S&P 500 that have payout ratios below 30%.

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Source: Thomson Reuters

Notably, Ford, JPMorgan Chase (JPM) and video game retailer GameStop (GME) make the grade on both counts.

Surely, companies with solid dividend yields and still-low payout ratios are worthy of further research -- but that research might tell you that GameStop faces serious challenges from the changing gaming environment, as more games are downloaded online and fewer are bought at stores. So it's wise to focus on companies that aren't facing obsolescence.

It's also wise to focus on companies that have shown a clear tendency toward robust dividend hikes. These are the firms most likely to keep focusing on increasing payouts.

So of the 37 companies in the S&P 500 that have both payout ratios below 30% and dividend yields above 2%, let's look at the ones that have boosted their dividends at least 10% in each of the past two years. (This analysis excludes companies such as Ford, as the automaker didn't have a dividend in 2010 and thus doesn't yet have a two-year track record through the end of 2012.)

The most aggressive dividend boosters have been in the banking sector, but looks are deceiving. All these banks maintained a nominal dividend in 2008 and 2009, and the subsequent rebound in payouts has seemed comparatively enormous -- though these banks are likely to boost their dividends at a more modest 10% to 20% pace in the years ahead.

Risks to Consider:Profit margins have been near record peaks in recent years, giving companies the confidence to be more generous with dividend payouts. If margins reverse course -- especially as companies start to boost employees' pay -- then companies may look to adopt a more conservative stance on dividend growth.

Action to Take --> Focusing on dividend payers with low payout ratios can point the way to steady dividend hikes. The low payout ratios also leave a nice margin of error in the event that cash flow growth slows. These relatively conservative payout strategies increase the chance that the dividend will at least be maintained at current levels, even if the economic climate darkens.